If I burn the bootloader version where I do not require the chip to use external crystal then I can eliminate the need of the 22pF cap and the external 16Mhz crystal ? Is it necessary to pull up the RESET pin to HIGH(5V) ??

The initial design of the Arduino LilyPad had a 10-pin ICSP header and used the internal clock on the ATmega168 rather than an external oscillator. The bootloader on the initial design is the traditional NG bootloader.

So you could probably do something like make a new boards.txt entry for a '328 or '328P with appropriate fuse settings for internal oscillator.